FALLING SHORT: INTERGOVERNMENTAL
TRANSFERS IN CHINA1
Yongzheng Liu
School of Finance
Renmin University of China
E-mail: yongzheng.liu@ruc.edu.cn
Jorge Martinez-Vazquez
International Center for Public Policy
Georgia State University
E-mail: jorgemartinez@gsu.edu
Baoyun Qiao
China Academy of Public Finance and Policy
Central University of Finance and Economics
E-mail: baoyun.qiao@gmail.com
ABSTRACT
This paper provides quantitative and qualitative assessments of the equalization impact
on regional fiscal disparities of the current fiscal transfers system in China. It also discusses
the main problems with the design of transfers and the options for their reform. In particular,
by using provincial level data for the period 1995-2011 and county level data for the period
1995-2005, we document the trends in own revenue disparities across and within provinces
and analyze how the different types of fiscal transfers have affected these two types of disparities. The paper also examines how expenditure disparities have translated into disparities in
service provision and simulates the additional amounts of funding needed from equalization
grants to bring the less well-off provinces to the country average for service provision.
1. INTRODUCTION
The most recent reform that has been undertaken by China’s central government in the area of intergovernmental fiscal relations is the so-called “taxsharing system” or TSS reform in 1994, which largely reshaped the fiscal
1. We would like to thank the editors and two anonymous referees for helpful comments and
suggestions, which helped improve the paper. We also thank Shaozhe Zhang and Wei Zhou
for their help with data collection. This research was supported for Liu by the Fundamental
Research Funds for the Central Universities, and the Research Funds of Renmin University of
China (14XNF003) and for Martinez-Vazquez by the Spanish Ministry of Economy and
Competitiveness under project No. ECO2012-37572 and for Qiao by the National Natural
Science Foundation of China (71373292).
Public Finance and Management
Volume 14, Number 4, pp. 374-398
2014
ISSN 1523-9721
375
Intergovernmental transfers in China
landscape in China by recentralizing revenues while at the same time further
decentralizing expenditure responsibilities. A natural outcome of this reform
in revenue and expenditure assignments---indeed one that has been frequently
and increasingly criticized---was the creation of large horizontal fiscal disparities across subnational governments (Wong 1998, 2000; World Bank 2002;
Martinez-Vazquez et al. 2008; Zhao 2009; Martinez-Vazquez and Qiao 2011).
These disparities pose serious threats for the cohesion of the nation. For one
thing, increasing horizontal disparities in the allocation of fiscal resources is
leading to inequitable fiscal outcomes at the sub-national level; in particular,
there is a lack of access to basic public services by many residents in poor and
rural local jurisdictions of China (Bahl 1999; Uchimura and Jutting 2009; Jin
and Sun 2011; Shen et al. 2012). In addition, from an efficiency viewpoint,
large disparities in the availability of public services lead to economically inefficient migration patterns and geographical allocation of economic resources;
the increase in fiscal disparities has become an increasingly significant obstacle to the country’s economic growth and political stability (Knight and Li
1999; Bird and Wong 2005; Wang et al. 2000).
As a supplementary policy tool to potentially ameliorate regional fiscal
disparities, a formal intergovernmental fiscal transfer system was first established in the 1994 reform. Despite the fact that the central government has
been increasingly stepping up its efforts to strengthen the role of the transfer
system, most of the current studies reach the same conclusion that fiscal disparities have remained high in the post-1994 era---indicating a limited equalizing (if not anti-equalizing) effect of the system (Knight and Li 1999; Ahmad et
al. 2004; Dabla-Norris 2005; Tsui 2005; Heng 2008; Martinez-Vazquez et al.
2008; Zhao 2009; Huang and Chen 2012; Wang and Herd 2013). In particular,
based on relevant methods to decompose the sources of fiscal inequality indices, Tsui (2005), Heng (2008) and Zhao (2009) find evidence that fiscal transfers from the central government do not shrink but indeed widen fiscal disparities at both the county and provincial levels. In contrast, Huang and Chen
(2012), Jin et al. (2013), and Wang and Herd (2013) detect some equalizing
elements of the system, though the overall equalizing effect is limited---in
large part due to the offsetting effects from different components of the transfer system.
Nevertheless, the design of any system of transfers is a complex matter,
and in practice very few countries are able to get it right, especially when the
decentralized system of finance is still fairly new. In this paper we focus exclusively on the analysis of the existing transfer system in China and aim to
provide both quantitative and qualitative assessments on the existing regional
fiscal disparities and the overall equalization effect of the transfers system.
Liu, Martinez-Vazquez & Qiao
376
Our paper differs from previous studies in several important ways. Specifically, we analyze the following: (a) the own revenue disparities across and within
provinces; (b) the equalizing/un-equalizing effects of fiscal transfers and its
components on revenue disparities across and within provinces; (c) how disparities in expenditure finally translate into disparities in service provision; (d)
how much additional funding would be needed from the central government to
bring the less well-off provinces to the country average; and (e) the possible
options for comprehensive reform.
The rest of the paper is organized as follows. In section 2, we first review
the basic setup of the current transfer system. In section 3 we use both provincial level data for the period 1995-2011 and county level data for the period
1995-2005 to analyze the existing regional disparities in fiscal resources and
the equalization effect of the current fiscal transfer system. In section 4, we
summarize the main structural problems with the current transfer system and
propose some options for comprehensive reform of China’s transfer system.
The last section concludes.
2. A BRIEF PERSPECTIVE ON INTERGOVERNMENTAL TRANSFERS IN CHINA
In 1994, the Chinese government implemented the TSS reform classifying
all taxes into three categories: central taxes, shared taxes, and local taxes between the central and local government.2 Meanwhile, separate central and local tax bureaus were established at the provincial, city/prefecture, county, and
township levels. The central tax bureau was put in charge of collecting central
taxes and most of the shared taxes, while the local tax bureaus were made responsible for the collection of all local taxes.
In addition to rearranging revenue assignments between the central and local governments, the TSS reform introduced for the first time in China rules2. Central taxes include the tariff and tonnage tax, the consumption tax and VAT levied by the
customs, the consumption tax and income tax from enterprises that are subordinate to the central government, the income taxes from rail transportation, state post, state-owned commercial
banks, and head office of insurance companies. Local taxes include the business tax and urban
infrastructure tax (other than from the headquarters of banks, and insurance companies, and
rail transportation), the income tax from locally owned enterprises, the urban land use tax, tax
on occupation of arable land, VAT on land, the property tax and inheritance tax, the contract
tax, the motor-vehicle and ship use tax, the agriculture tax, the banquet tax, the livestock
slaughter tax, the farmland conversion tax, and the reorientation tax on capital construction.
Shared taxes include VAT (75% central; 25% local), the personal income tax and enterprise
income tax (50:50 in 2002; 60:40 from 2003), the urban infrastructure tax (rail transportation,
headquarters of banks and insurance companies 100% central, others 100% local), the resource tax (offshore 100% central and on land, 100% local), and the stamp tax on security
transactions (97% central; 3% local).
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Intergovernmental transfers in China
based intergovernmental fiscal transfer programs with the objective of accommodating gaps in fiscal capacity and expenditure needs across local jurisdictions.
However, after twenty years in operation, the new system of transfers has
been only partially successful at that objective. The limited equalization impact of the intergovernmental transfers has been due in part to its initial design.
As an important example, which is further discussed below, the TSS reform
introduced the “tax rebates” as a “hold harmless” compensation for the richer
provinces, which ended up being a major component of the transfer system
with persistent highly un-equalizing results. The general-purpose equalization
transfers later introduced in 1995 have only played a limited role in offsetting
existing fiscal disparities. Overall, intergovernmental transfers from the center
to the provinces are still not well developed. The situation is worse for transfers from provincial to local governments where, in all these years, no transparent framework has emerged. In what follows we take a closer look at the
current transfer system at both levels.
2.1 Central-Provincial Transfers
Under the current setting, fiscal transfers from the central government to
the provincial governments can be broadly categorized into three main types:
(1) The tax rebate. The tax rebate, a compromised outcome to smooth the
implementation of the TSS reform, was introduced to guarantee the vested interests of provincial governments prior to the reform. Its essence was to return
to the provinces the amounts of VAT, consumption taxes and income taxes
that otherwise would have gone to these provinces under the system existing
prior to the reform. More specifically, the tax rebates on VAT and consumption taxes considered 1993 as the base year and, beginning in 1994, all provinces were guaranteed to receive at a minimum the VAT and consumption tax
revenues they had retained in 1993.3
In 2002, the corporate income taxes and personal income taxes became
shared taxes as opposed to local taxes, and so additional rebates on income
taxes were introduced to protect the vested interests of local governments. In
particular, if the amount of income tax revenues received by local governments under the new sharing scheme were to be less than what they received
3. See Zhang and Martinez-Vazquez (2003) for a more detailed description of the formula
used in the calculation of the rebate amount.
Liu, Martinez-Vazquez & Qiao
378
in 2001, the central government was supposed to provide additional income
tax rebates to fill the gaps.
Although quite significant in absolute terms in the initial years, because
the tax rebates were determined on the basis of the nominal collections of the
base year, the relative importance of the income tax rebates, as was the case
for the VAT and consumption tax rebates, has been rapidly decreasing over
time.
(2) The system of equalization transfers. Currently, the equalization system
in China involves a number of formula and non-formula-based transfers, all of
which have in common the general objective of reducing horizontal fiscal disparities. And while over time the relative importance of transfers with equalization objectives has grown steadily, that of tax rebates has continued to decline. Transfers with an equalization objective include the following:
(a) The “transitory period transfers” (renamed “general-purpose grants” after 2001). This transfer represents the first formula-based transfer program introduced in China, with an explicit equalization objective to reduce fiscal disparities across provinces. The amount of the transfer is determined by a formula based on the computation of a standard revenue and standard expenditure by the central authority. Standard revenues are measured by using estimates of the tax bases and the standard tax rate. Standard expenditures are calculated using a myriad of expenditure needs categories including spending on
administration services, public safety, education, urban maintenance, social
assistance, and heating.4 Note that even though the origin of this transfer can
be traced back to 1995, just after the TSS reform, the general-purpose grant
was only first explicitly budgeted for in 2001. And it was only in 2012 that the
Ministry of Finance set up the current formal standardized approach to calculate the equalization transfer. These changes have much improved the stability
and transparency of this category of transfers.
(b) The “pre-tax sharing system grants”. These grants are actually the contracted fixed grants existing under the “contracted fiscal system” before the
TSS reform in 1994. These transfers have ensured that the “poor provinces”
have total nominal revenues that are not less than what they were in 1993. At
the present time there are only about 16 provinces receiving these grants. Most
of these provinces are in the central and western regions of the country.
4. The calculation method can be found in "The methods of the central to local equalization
transfer
in
2012",
see http://yss.mof.gov.cn/zhengwuxinxi/zhengceguizhang/201207/t20120725_669218.html.
379
Intergovernmental transfers in China
(c) The transfer to minority regions. This transfer was launched in 2000
with RMB 1 billion to further support the development of minority regions.
The pool of funds is composed of two parts: the first part is financed directly
from the central budget with a yearly growth rate equaling the growth rate of
centrally shared VAT revenues;5 the second part is 80% of the total amount of
the yearly increase in collections for the central government share of the VAT
collected in minority regions.
(d) Transfers for increasing the wage standard of civil servants. These
transfers were designed to support provinces in the central and west regions of
the country for the implementation of policies mandated by the central government for increasing the wage standard of civil servants. The main justification was that without this fiscal assistance from the central government, many
provinces in these regions would have faced serious fiscal difficulties complying with the wage mandate.
(e) Transfer for the rural “Tax-for-Fee” reform6 and the elimination of the
agriculture tax. The purpose of this transfer was to partially compensate local
governments for the revenue losses caused by the implementation of the rural
“Tax-for-Fee” reform in the early 2000s and the complete abolition of the agriculture tax in 2006.
(f) Other general-purpose transfers with an equalization objective. These
include, among others, transfers to cities suffering from natural resource exhaustion, transfers for the replacement of the local market place management
fee and the industry and commercial entity fee, transfers for supporting the Oil
Tax and Fee Reform, and transfers for regions with important ecological functions.
(3) Earmarked specific transfers. As of 2013 there were 220 specificpurpose grants. The plans are that one third of these programs will be cut in
the 2014 budget. Earmarked specific transfers typically involve the central
government response to high-priority emergencies or are generally associated
with particular programmatic objectives; some examples include fiscal stimulus packages, bail-outs of local government social protection programs, or the
“compulsory education transfer” introduced in support of the rural compulsory
education program.
5. Note that the base pool of these funds is RMB 1 billion in year 2000.
6. See Lin and Liu (2007) for a detailed description of the reform, and Wang and Zhao (2012),
Alm and Liu (2013) for an analysis on its potential impacts.
Liu, Martinez-Vazquez & Qiao
380
2.2 Transfers Below the Provincial Level
The 1994 TSS reform is generally perceived as an incomplete reform because it formally regulated only the intergovernmental fiscal relations between
the central and provincial governments, leaving ample discretion for provincial governments to set up their own fiscal relations with their local (subprovincial) governments. For this reason, fiscal arrangement schemes at the
sub-provincial level vary from province to province (Shen et al. 2012). In general, however, these sub-provincial arrangements follow the basic setup of the
center-provincial system and fiscal transfers there can also be loosely categorized into three groups: tax rebates, equalization transfers, and ad hoc transfers.
But generally speaking the sub-provincial transfer systems are less well developed and their main focus is still the pre-TSS reform practice of filling the
gaps between current revenues and expenditures.7
3. EQUALIZATION IMPACT OF THE CURRENT TRANSFER SYSTEM
3.1 Horizontal Revenue Disparities Across and Within Provinces
China’s intergovernmental finance system has been characterized by persistent horizontal fiscal disparities across provinces and within provinces, especially when the focus is on those tax revenues fully assigned to the subnational governments. Here we review the trends in these fiscal disparities
across and within provinces.8
Horizontal disparities in own revenue across provinces: Revenue assignments generate pronounced fiscal disparities across provinces, especially for
the very distinct eastern region—relatively rich, and the central and western
regions—relatively poorer. Over time these disparities have not become less
pronounced. In fact, after the 1994 TSS reform, horizontal regional disparities
in sub-national own revenues deteriorated (Table 1). A significant contributing
factor has been the different rates of economic growth in the different regions.
Over time the coefficient of variation for per capita own revenues increased
reaching a peak in 2005 of 1.28 and slightly declining in more recent years.
These horizontal disparities are also reflected in the ratio of the maximum to
minimum own revenues per capita across provinces. This ratio stood at 11fold in 1993 just before the TSS reform and reached a peak in 2005 of 20-fold;
7. For more detailed discussions of the sub-provincial fiscal system in China, see Wong (1994)
and MOF (2006).
8. Where there are differences in the level of economic development, there are differences in
fiscal capacity and these differences are naturally enhanced with higher levels of tax autonomy. Most countries deals with this issue by strengthening the equalization grant system.
Intergovernmental transfers in China
381
in recent years the ratio has decreased only slightly, still standing at 18-fold in
2011.
Table 1. Per Capita Disparities in Own Revenue across Provinces,
1986-2011
Year
Mean
C.V.
Min
Max
1986
136.6
1.51
29.4
1063.3
1987
133.2
1.34
30.2
913.4
1988
116.4
1.18
37.6
720.0
1989
111.9
1.07
37.3
634.4
1990
110.7
1.04
38.6
604.8
1991
116.1
0.92
42.8
541.1
1992
112.9
0.90
44.7
518.1
1993
129.5
0.84
51.1
561.3
1994
74.2
0.90
27.4
326.1
1995
80.8
0.86
26.9
329.6
1996
93.7
0.88
31.6
384.5
1997
101.1
0.93
34.0
431.8
1998
118.9
0.95
39.2
492.1
1999
134.5
0.99
44.3
555.2
2000
149.5
1.04
48.2
725.2
2001
184.3
1.17
56.1
1060.9
2002
202.6
1.21
62.2
1197.7
2003
232.2
1.25
70.1
1427.6
2004
265.6
1.24
80.1
1575.0
2005
334.1
1.28
101.5
2109.2
2006
397.3
1.25
117.2
2532.7
2007
484.3
1.25
146.6
3071.7
2008
552.2
1.23
164.1
3531.8
2009
630.4
1.24
192.4
4124.0
2010
733.8
1.16
232.2
4611.7
2011
895.5
1.11
291.3
5473.1
Notes: Values are calculated at real per capita term.
Source: China Statistical Yearbooks and Authors' Calculation.
Own revenue disparities within the provinces: Two types of factors influence fiscal disparities within the provinces. First, an important feature of China’s intergovernmental finance system is that provinces have almost complete
discretion to design the revenue assignments they implement for their subprovincial governments. And in fact revenue assignments within each prov-
Liu, Martinez-Vazquez & Qiao
382
ince can be quite different. Second, there are often significant differences in
the levels of economic development and therefore tax bases across jurisdictions within the provinces. Having a strongly hierarchically vertical government structure potentially compromises the effectiveness of national equalization policies in China. Final equalization outcomes clearly also depend on the
equalization policies implemented by the provincial governments.
Table 2 shows the disparities in own revenues per capita across counties
within each province from 1995 to 2011. The figures clearly indicate significant levels of disparity within provinces, which vary over time and with trends
that differ significantly across provinces. While within-province disparities
have declined in the eastern region, which, again, comprises the richest provinces in China, the trends in other regions have been oscillating or have increased quite significantly as in the cases of the northwest and southwest regions. On average, the coefficient of variation for per capita own revenues
within provinces only changed slightly over the observed period; it increased
from 1.1 in 1995 to a value around 1.3 in 2005, and then declined to a value
around 1.0 by 2011.
Even so, as shown in Figure 1, own revenue disparities within provinces
have become less pronounced across different provinces over the period 19952011; the provinces with the highest initial levels of disparities in own revenue
registered the largest drops, while the provinces with low initial levels of disparities in own revenue generally experienced an increase in within-province
disparities. This point is consistent with what was found in Wang and Herd
(2013).
It thus appears that if the central government cares about reducing horizontal fiscal disparities, then central government policies need to take into account
the existing horizontal fiscal disparities within the provinces and to consider
the best way to do that given China’s strong hierarchical vertical structure of
government.
Own revenue disparities within vs. across provinces: In order to document
the relative importance of own revenue disparities within provinces and across
provinces in contributing to the overall revenue disparities in the nation, we
calculate the Theil index based on county data that provides a way to decompose the overall disparities into disparities between groups and disparities
within groups. As shown in Figure 2, revenue disparities are starker within
provinces than across provinces, suggesting that revenue disparities within
provinces are the main contributor to the overall revenue disparities in the nation. This is related to the very different economic experience of counties
within a province. However, over the years, own revenue disparities across
provinces experienced a large increase from a value around 0.13 in 1995 to a
Intergovernmental transfers in China
383
Table 2. Per Capita Own Revenue Disparities within Provinces,
1995-2011
Mean
C.V.
Min
Max
1995
2005
2011
1995
2005
2011
1995
2005
2011
1995
2005
2011
Beijing
367
3030
8586
0.6
0.5
0.6
18
1010
2889
741
6092
20516
Tianjin
793
1368
6410
2.8
0.6
0.7
125
526
1834
9954
2906
14893
Hebei
132
599
1012
1.8
3.2
0.9
33
37
154
2521
20445
6393
Shanxi
132
413
1716
0.6
0.7
0.8
24
56
209
470
1562
5649
Mongolia
150
1104
4107
1.1
1.1
1.6
37
93
167
1537
5312
40509
Liaoning
266
720
3191
2.6
1.7
0.5
46
76
692
6870
11696
7472
Jilin
97
272
1519
0.7
0.6
0.5
29
83
336
348
1036
3500
Heilongjiang
155
299
1113
1.3
2.0
1.3
49
41
170
1784
4957
10691
Shanghai
907
6596
8302
0.7
0.4
0.8
396
2749
3443
3215
11245
30694
Jiangsu
156
1707
5441
0.7
1.3
0.9
37
128
1451
456
15980
27655
Zhejiang
273
2149
3636
2.3
1.5
0.6
46
320
918
4355
26499
10909
Anhui
108
268
1267
0.4
0.8
0.8
48
41
164
335
1377
4879
Fujian
210
863
1788
0.5
1.7
0.7
88
144
607
710
9499
7548
Jiangxi
137
345
1546
0.9
0.4
0.6
40
104
326
1193
784
5886
Shandong
175
858
1965
2.2
1.8
0.8
36
109
410
3822
17022
7491
Henan
88
383
916
0.7
1.1
1
27
54
191
308
3576
4596
Hubei
94
303
952
0.5
1.1
0.7
31
53
148
273
2326
3614
Hunan
131
375
777
0.6
1.4
0.9
34
64
277
538
4110
5218
Guangdong
168
867
1144
1
2.6
0.9
32
58
168
878
21394
5577
Guangxi
114
335
775
0.5
1.9
0.9
24
65
182
349
6239
4208
Hainan
188
246
1567
0.6
0.7
0.7
69
24
610
588
765
4411
Chongqing
106
437
5219
0.9
0.9
0.4
41
83
2761
504
1654
10399
Sichuan
106
271
1047
0.7
1.2
0.9
5
40
141
486
1834
6395
Guizhou
76
285
842
0.7
1.1
0.7
22
69
199
375
2018
2865
Yunnan
156
340
1051
0.9
0.9
0.9
20
55
198
838
2117
8076
Shaanxi
86
410
1431
0.7
2.2
1.8
13
28
121
334
6117
14813
Gansu
102
218
951
1.1
1.5
2.2
8
19
98
582
2431
16330
Qinghai
124
326
1597
0.9
1.4
2.7
29
22
98
517
2121
25941
Ningxia
58
359
1899
0.8
0.8
1
6
39
138
176
790
6086
Xinjiang
160
536
2573
2.1
1.4
1.2
2
39
229
3029
6088
16840
Mean
194
876
2478
1.1
1.3
1
47
208
644
1603
6666
11335
Source: Ministry of Finance, China Statistical Yearbook for Regional Economy, and Authors’
Calculation.
Liu, Martinez-Vazquez & Qiao
384
Figure 1. The Initial Level and Changes of Within Province
Own Revenue Disparity
Note: changes in within-province own revenue disparity are calculated as the difference of
coefficient of variation of per capita county revenue within province for the years 2011 and
1995. Source: Ministry of Finance and Authors’ Calculation.
Figure 2. The Decomposition of Own Revenue Disparities, 1995-2011
Source: Ministry of Finance, China Statistical Yearbook for Regional Economy, and Authors’
Calculation.
385
Intergovernmental transfers in China
value around 0.36 in 2008, while own revenue disparities within provinces
experienced a moderate decrease in this same period. In summary, own revenue disparities are larger within provinces than across provinces, but this difference has been diminishing over the years. The relative large value of own
revenue disparities within provinces has also dominated the trends of overall
own revenue disparities in the country.
3.2 Relative Equalizing Effects of Transfers
The transfer system reduces disparities across provinces but not enough:
Here we perform a simple exercise to analyze how the disparities in the prime
initial disparities in “own revenues” per capita evolve as we progressively and
cumulatively add the other financing sources in the system: first the tax rebates, second the ad hoc transfers, and third the equalization grants. We also
present side by side the distribution of expenditures per capita. If the overall
impact of transfers is equalizing, we should end with lower disparities in the
distributions of expenditures per capita than in the distribution for own revenues, but the question remains how much smaller the disparities in expendiFigure 3. Impact of Fiscal Transfers on Provincial Disparities
in Revenues and Expenditures
Note: Figures are calculated at real per capita term. Own revenue is added by tax rebate, ad
hoc transfer, and equalization transfer continuously. After the equalization transferred is added,
it is equivalent to adding own revenues to total transfers. Data for the decomposition of transfers at the provincial level are only available up to 2004.
Source: China Statistical Yearbooks and Ministry of Finance.
Liu, Martinez-Vazquez & Qiao
386
tures per capita should be. The results of the exercise are presented in Figure 3.
Three things are especially noticeable: (1) provincial disparities in own revenues increased after the 1994 TSS reform, something already noted; (2) the
overall effects of transfers is equalizing since provincial disparities in expenditures per capita are significantly lower than the disparities in own revenues per
capita, results that confirm the recent similar findings in Huang and Chen
(2012), Jin et al. (2013), and Wang and Herd (2013). However, the final distribution across provinces in expenditures per capita still shows considerable
disparities by international standards; (3) provincial disparities in both revenues and expenditures per capita appear to have declined in the most recent
years---a result that is partially due to the increase of the share of the equalization transfers and the corresponding decrease in the share of tax rebates in the
overall transfer pool.
Equalization effectiveness of transfers differs significantly across the type
of transfers: As shown in Figure 3, the equalization effects of fiscal transfers
vary across different components of the transfer system. In general, as is to be
expected, the tax rebates do not perform any equalization role but in fact lead
to increased disparities across provinces in the early years. As we already
pointed out, the tax rebate was designed as a compromised outcome to smooth
the acceptance of the TSS reform by the richer provinces in 1994. On the other
hand, both the ad hoc transfers and the equalization transfers have contributed
to lower levels of regional disparities in available per capita resources. 9 In addition, Figure 3 also shows that the equalization effect of those two types of
transfers has increased over the years, in large part due to the increased pool of
funds dedicated by the central government to these categories of transfers. Recall also that another significant factor for the higher equalizing trend is the
fact that the actual volume of the tax rebate was fixed in nominal terms in
1994 and that therefore it has been decreasing in relative importance over the
years.
Practically all of the previous results have been at the central-provincial
level and this evidence should be interpreted as preliminary from simple descriptive analysis. In order to analyze the equalizing and/or un-equalizing effects of the different components of the transfer system more rigorously, we
conduct empirical tests to examine the basic relationship between different
components of the transfers and the economic development level of the jurisdiction (proxied by per capita GDP) at both the central-provincial level and the
provincial-county level. Given data limitations at the county level, we are only
able to decompose total transfers at this level into two categories, tax rebates
9. While it is generally agreed in the literature that equalization transfers contribute to a lower
level of revenue disparities, the equalizing/un-equalizing effect of the ad hoc transfers is found
to be mixed in the previous studies (e.g., Heng 2008; Huang and Chen 2012).
Intergovernmental transfers in China
387
and all other transfers, which include the equalization transfers and ad hoc
transfers. We run a set of panel regressions with per capita transfers as the dependent variable and per capita GDP as the main explanatory variable. In addition, we introduce several other control variables that may affect the transfers received by the jurisdiction. These include total population, the share of
population residing in rural areas, the share of public employees in the total
population, and the lagged per capita fiscal deficit (defined as the difference
between per capita fiscal expenditures and per capita fiscal revenues). In the
estimations, we also include the province fixed effects and year fixed effects
in order to control for the unobserved time-invariant heterogeneity and timevarying characteristics.
Table 3. Determinants of Different Components of Transfers
Central-Provincial Transfers
Provincial-County Transfers
Equalization
Tax rebate
and others
(4)
(5)
Tax rebate
Equalization
Ad hoc
(1)
(2)
(3)
0.036***
-0.023***
-0.013***
(7.020)
(-6.357)
(-2.818)
(-2.725)
(6.951)
0.002
-0.009
-0.023
-0.398***
-0.188***
(0.642)
(-1.069)
(-1.181)
(-3.583)
(-3.523)
Share of rural
0.772***
-0.264
-0.998**
-0.068
-0.254**
population
(2.871)
(-0.879)
(-2.282)
(-0.537)
(-2.575)
Share of public
222.477***
18.691
58.653
60.108***
0.795
employee/pop
(3.847)
(0.219)
(0.460)
(8.344)
(0.231)
Lag fiscal deficit
-0.006
0.356***
0.443***
0.233***
0.027
(-0.865)
(12.193)
(4.921)
(2.717)
(0.526)
Province dummies
Yes
Yes
Yes
Yes
Yes
Year dummies
Yes
Yes
Yes
Yes
Yes
Observations
269
269
269
11,610
11,506
GDP per capita
Population
per capita
-0.004***
0.011***
Note: The sample period for estimations at the central-provincial level and provincial-county
level are 1995-2004 and 1995-2005 respectively; t-statistics are in parentheses; GDP per capita is treated as an endogenous variable and it is instrumented by one-year and two-years lags
of GDP per capita; Newey-West standard error is calculated in the estimations; *** p<0.01,
** p<0.05, * p<0.1.
An important concern in estimating the model is that of the potential endogeneity of the economic development variable. This issue may arise due to
the fact that increasing the transfers received by local governments is indica-
Liu, Martinez-Vazquez & Qiao
388
tive of more fiscal resources available and at the discretion of local governments. Therefore, it is quite possible that local governments may have used the
transfers they received to promote local economic development. To circumvent the endogeneity issue, we use an instrumental variable approach. The instruments we use for the economic development variable are the one-year and
two-year lag in per capita GDP. This is justified in the way that, by its nature,
the lags in the economic development variable are correlated with the variable
at present, while the transfers received by a locality in the later years should
virtually have no significant impact on the economic development level in the
past. Finally, we also correct for the potential heteroskedasticity and autocorrelation by reporting the Newey-West standard errors in the estimations.
The regression results are presented in Table 3. As expected, the coefficient for per capita GDP is positive and statistically significant in the regressions for tax rebates (columns (1) and (4)). Thus, it confirms the un-equalizing
nature of tax rebates at both the central-provincial level and provincial-county
level---better-off provinces/counties receive more per capita tax rebates. However, the coefficient for per capita GDP is negative and significant in the regression for all other transfers (columns (2), (3), and (5)), which again is consistent with what we concluded above that both equalization transfers and ad
hoc transfers are somewhat equalizing. Nevertheless, the marginal unequalizing effect of the tax rebates is relatively larger and it overwhelms the
marginal equalizing effect of other transfers.
As far as the control variables are concerned, total population is negatively
associated with all types of transfers received, but it is only statistically significant in the estimations at the provincial-county level. Fiscal deficit in the previous year generally leads to a higher level of transfers received, particularly
for ad hoc transfers and equalization transfers. The share of rural population
and the share of public employees in the total population appear to have inconsistent signs across the different estimated equations.
The impacts of fiscal transfers on revenue disparities within provinces vs.
across provinces: Given the results above, of greater revenue disparities within provinces than across provinces, we are interested to see how the current
transfer system may affect the within and across-province disparities differently. To explore this further, we follow the previous methods to add own revenues by tax rebates and all other transfers continuously at the county level, and
then calculate the corresponding Theil indexes to decompose the overall disparities into disparities within provinces and between provinces.
The results are presented in Figure 4. Three noticeable trends are apparent.
First, both own revenue disparities within provinces and across provinces are
reduced by the transfer system, and the overall equalizing effect is increasing,
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Intergovernmental transfers in China
especially in recent years. This result contrasts with the general observation in
the literature that the transfer system had not reduced fiscal disparities at the
sub-provincial level (Tsui, 2005; Zhang and Zheng, 2010), but it is in turn
consistent with the most recent findings by Wang and Herd (2013). Second,
considering the magnitudes of the effects, the reduction of revenue disparities
within provinces is relatively larger than the reduction in revenue disparities
across provinces. As shown in Figure 4, even the tax rebates play a minor role
in reducing revenue disparities within provinces; however, they play virtually
no role in reducing the revenue disparities across provinces.10 Third, revenue
disparities within provinces remain high. Despite the equalizing effects of the
transfer system, revenue disparities within provinces are still more than twice
as large as revenue disparities across provinces.
Figure 4. Impact of Fiscal Transfers on the Decomposition of Provincial
Disparities in Revenues and Expenditures
Note: Figures are calculated at per capita term. Own revenue is added by tax rebates and all
other transfers continuously.
Source: Ministry of Finance and Authors’ Calculation.
10. Indeed, tax rebates enlarge the revenue disparities across provinces in the early years of
the reform.
Liu, Martinez-Vazquez & Qiao
390
3.3 Linking Expenditure Per Capita to Differences in Access to Public
Services
The most important determinant of access and quality of basic public services is the level of public expenditures. So it is logical that we ask what the
relationship is between disparities in expenditures per capita and disparities in
service provision. To answer this question we look at the evolution over time
of disparities in service provision and the correlation between expenditure per
capita and access to service provision. Our focus here will be on education
services.
In fact there is a significant correlation between real per capita provincial
expenditure on education and the intermediate output measure of the ratio of
teachers per 1,000 students in primary schools (Figure 5(a)). In addition the
dispersion for both variables, as shown by the coefficients of variation in Figure 5(b), did rise steadily over the period up to 2005 followed by a fast decline
in the subsequent years. It could be that this change is related to the “provincemanaging-county” reform introduced by the central government around that
time,11 which meant that some provincial governments started to directly manage their county governments thus bypassing the prefecture level. The reversal
in trend indicates some convergence across provinces on the budgetary priority given to this basic service. Nevertheless, with coefficient of variation of 0.8
in 2011, the disparities in education outputs still remain too high.
4. OPTIONS FOR THE REFORM OF THE CURRENT TRANSFER
SYSTEM
China’s system of intergovernmental transfers has been evolving over the
past two decades, but it has retained its fundamental nature of origin-based
shared taxes supplemented by grants and subsidies for a myriad of purposes
and with considerable redundancy. The end result has been a limited degree of
equalization among provincial and sub-provincial governments and a complex
system of transfers by any standards.12 Even though in some functional areas
disparities have decreased, overall disparities across provinces in available per
capita fiscal resources and actual expenditures per capita remain very high by
international as well as China’s own historical standards. In this subsection,
11. Using a panel data set of 108 counties in Henan province for the years 1999-2008, Wang
et al. (2012) find that the “province-managing-county” reform reduces local governments’
spending on education. However, if the “province-managing-county” reform was predominantly implemented in provinces with originally high education expenditures, then the trend in
declining of disparities in education expenditure across provinces can still be observed.
12. See Zhang and Martinez-Vazquez (2003).
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Intergovernmental transfers in China
we review the main issues of the current system and propose several options
for the possible reforms of the system.
Figure 5. Mean and Coefficient Variation of Per Capita Education
Expenditure and Number of Teachers Per 1,000 Primary Students,
1986-2011
Source: China Statistical Yearbooks and Authors’ Calculation.
4.1 Additional Funding Needed from the Central Government
In terms of the total pool of funds we have seen above that there has been a
steady increase in the dedicated funds, but these have not been enough to reduce the still very high expenditure per capita disparities across provinces.
Thus, the first relevant question is how much additional funding would be
needed from the central government---for example in some form of equalization grant---to bring the less well-off provinces to the country average.
There are actually many possible ways to answer this question. A simple
but still quite informative approach is first to select the national average fiscal
capacity as the normative measure of fiscal need for the provincial governments. With this we then can calculate the increase in the overall pool of funds
for transfers required to bring provinces with fiscal capacity below the nation-
Liu, Martinez-Vazquez & Qiao
392
al average to the national average.13 The calculation of the national average of
fiscal capacity can be based on a measure using only “own revenues” or alternatively using total revenues including transfers from the central government.
Our calculations indicate that these amounts would have been 979,273 million
and 933,276 million respectively, based on average values for 2009-2011.14
This would represent 28.8% and 27.4%, respectively of the total central government transfers (average values for 2009-2011). Although by no means insignificant these are feasible levels of additional funding if done over a period
of several years.
A significant portion of the required funds could come from a parallel
structural reform granting more revenue autonomy to the provinces; this type
of reform would mostly benefit the richer provinces, but the overall outcome
would be a reduction of intergovernmental transfers especially to the richer
provinces, which would benefit the most.15 On the down side, higher equalization transfers would no doubt increase the level of transfer dependence of
poorer provinces. However, the entire policy package—simultaneously increasing revenue autonomy and redistributing the recipients of transfers--would make the intergovernmental finance system more equitable by ensuring
that minimum service standards are provided to all citizens regardless in what
part of the country they live. The policy package would also have efficiency
benefits by limiting population migration driven simply by differences in the
standards of public service provision. There are also positive political economy aspects in the package, since both relatively richer and relatively poorer
provinces may perceive themselves as winners.
However, one caution we need to highlight here is that if the additional
funding is distributed through unconditional equalization grants, there is no
guarantee that the additional funds would be spent on essential social services.
The strong current incentives for subnational officials to spend on infrastructure and economic development projects would remain in place. Because of
13. We must emphasize that our simple approach leaves out considerations involving economies of scale and scope or demographic and geographic characteristics of the provinces. The
national standard could potentially be adjusted by an index incorporating differences in relative expenditure needs and costs of services.
14. Our calculation procedure is not reported in this paper, but it is available upon request.
15. As a matter of fact, our calculation of the transfer dependence (i.e. the ratio of fiscal transfers to total expenditure) over the past 15 years indicates that the general tendency has been
for richer provinces in the eastern region to become less reliant on transfers, at the same time
that relatively poorer provinces in the central and especially the western regions have become
increasingly more reliant on transfers. Given that there have been practically no changes in
revenue assignments in China over the past two decades, it is likely that these different trends
can at least be partially explained by the differing sizes of the regional economies and their
respective rates of growth.
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Intergovernmental transfers in China
this, a well-balanced increase in both unconditional equalization transfers and
conditional grants, especially sectoral block conditional grants, in some particular priority areas of expenditure/services would appears to be a more balanced desirable way to allocate the additional funding.
4.2 Bringing More Certainty to the Available Pool of Funds for Equalization
At present the pool of funds available for equalization is decided in the annual budget on an ad hoc basis. This brings budget uncertainty to the recipient
subnational governments and signals lack of commitment by the central government to the equalization objective, which may be sacrificed under budgetary pressures. In the international practice this issue of budgetary uncertainty
and lack of commitment is addressed by introducing a (funding) formula for
determining the pool of available equalization funds; one common such rule is
a percent of total tax revenues lagged one or two budget periods. Actually in
recent times the central government has moved toward the formalization of the
available pool of equalization funds by earmarking its share of income tax
revenues for equalization. But, of course, these are only a part of the overall
funds currently used for equalization.
4.3 Addressing the Fragmentation of Conditional Grants
Over the last several decades China has followed the path of many other
countries around the world using and abusing the system of conditional grants
to address new policy initiatives, emergencies or old problems that needed fixing. The result has been a complex and highly fragmented conditional grant
system, which imposes high administrative burdens on subnational governments. The fact that most of these conditional grants have matching fund provisions had added to heavy budgetary pressures on subnational governments.
To cope with these pressures subnational governments have used unorthodox
public accounting, such as “double-matching” or using the same funds to
comply with the matching provision in different grants.
In dealing with the issue of fragmentation the recent international experience shows that many countries have consolidated their myriads of conditional
grants into a much smaller number of block grants supporting national sectoral
strategies. The block grants are also conditional—that is, the resources need to
be used in a particular sector but they avoid micro-management by allowing
subnational governments more discretion for the very specific uses. However,
these grants tend to provide better balance between ensuring the use of resources in the pursuit of sectoral objectives and granting sub-national govern-
Liu, Martinez-Vazquez & Qiao
394
ments more budget discretion. Similar reforms could have a high payoff for
China.
4.4 Eliminating the Other Counter-Equalizing Elements in the Transfer
System
Existing horizontal disparities are to a large extent due to several policy
choices made within the framework of the 1994 TSS reform, which were fundamentally counter equalizing. At the top of those choices was the “tax rebate” which purportedly was introduced to buy the support of the richer provinces for the 1994 reform. Also of significant importance was the adoption of
revenue sharing on a derivation basis or where the money is collected. The
implication of the derivation basis is that richer provinces get to keep more
funds because they have tax bases.16
The un-equalizing role of the tax rebate has been reduced over time because by design the rebate was fixed in nominal terms. Similarly, the unequalizing effects of the derivation principle in tax sharing have been reduced
because the central government has increased its sharing rates for certain taxes
in recent years. Beyond increasing the pool of funds available, further equalization could be achieved by changing the allocation of the shared VAT revenues to a formula based on population. Of course, quite likely the wealthier
provinces would oppose this.
4.5 The Need to Further Formalize the Sub-Provincial Transfer System
Along the lines of a strong federalist system, something that formally China is not, provincial governments have virtually complete discretion to arrange
their fiscal relations with prefectures and cities, while the latter can do the
same vis-a-vis their counties, and so on. After the 1994 TSS reform subnational governments supposedly restructured their intergovernmental fiscal relations with lower-level governments. However, the general perception has continued to be that provincial and prefecture governments do not allocate funds
commensurate to the expenditure needs of lower level governments and that
often they retain funds originating at the center which were intended to reach
county and township level governments.
The question is whether or not subnational governments currently have too
much discretion on how to organize their intergovernmental fiscal relations
with their lower-level governments. High levels of discretion offer advantages
16. Merely as an indication, in 2000 just before income tax shares were amended, the nine
provinces in the coastal area (Beijing, Tianjin, Liaoning, Shangdong, Jiangsu, Zhejing, Fujian,
Shanghai, and Canton) collected about 70% of the total income taxes.
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Intergovernmental transfers in China
especially in a country as large and diverse as China. On the other hand, the
central government also needs venues to ensure the attainment of its own policy objectives, such as equalization. Thus there is a need to find ways to balance flexibility at the subnational level with the ability of the central government to implement its own policies and achieve its own policy objectives. The
“province-managing-county” reform has been a relatively recent move in that
direction; but even though this reform has helped to streamline vertical fiscal
relationships, it clearly falls short of reaching the right balance between subnational flexibility and ensuring national objectives.
Reaching a balance will likely require the redesign of the sub-provincial
transfer system. These reforms actually would closely resemble those needed
at the central level: setting aside sufficient funds for equalization grants, using
explicit funding rules to enhance predictability, and using improved allocation
formulas capturing the disparities in fiscal capacity and expenditure needs of
lower-level jurisdictions. All this may require more central government rules
and intervention in the subnational finances. The goal of granting all citizens
access to basic public services quite likely warrants it.
5. CONCLUDING REMARKS
One of the most significant policy objectives of the Chinese government at
the present time is to move toward a more equal society where all citizens
have access to basic public services regardless of where they live. Despite the
efforts until now, geographical disparities in expenditures per capita still remain too high, implying that access to basic public services is still too unequal
across the country. Going forward and getting closer to the goal of a more
equal and just distribution of services will require further increasing the overall pool of funds dedicated to equalization and making this increased funding
more stable and predictable by adopting an explicit funding rule for the available pool of funds. The current allocation formula also could be further improved by refining the measurements of expenditure needs and fiscal capacity.
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